Earnings Quality Decline

Journal of Accounting and Public Policy 25 (2006) 71–90
www.elsevier.com/locate/jaccpubpol
Earnings quality decline and the effect

of industry specialist auditors: An analysis
of the late 1990s
David S. Jenkins *, Gregory D. Kane 1, Uma Velury 2
University of Delaware, Department of Accounting and Management Information Systems,

Newark, DE 19716, United States
Abstract
This study investigates whether earnings quality declined during the late 1990s, a per-
iod marked by extraordinary stock market activity, and whether industry specialist
auditors were effective in stemming any such decline. Specifically, we examine whether
the magnitude of discretionary accruals increased and the Earnings Response Coeffi-
cient (ERC) decreased in the 1997–1999 period relative to those of the 1990–1996 per-
iod. Our findings are as follows. First, we find a significant increase in the magnitude of
discretionary accruals and a significant decrease in ERC in our sample, which suggests
an overall decrease in earnings quality across the periods. Next, both the increase in dis-
cretionary accruals and the decrease in ERC are shown to be significantly smaller for
clients of industry specialist auditors. Finally, it is shown that the effectiveness of indus-
try specialist auditors was limited and that they were associated with some earnings
*
Corresponding author. Tel.: +1 302 831 6823.
E-mail addresses: jenkinsd@udel.edu (D.S. Jenkins), kaneg@udel.edu (G.D. Kane), veluryu@
udel.edu (U. Velury).
1
Tel.: +1 302 831 6826.
2
Tel.: +1 302 831 1764.
0278-4254/$ - see front matter Ó 2005 Elsevier Inc. All rights reserved.
doi:10.1016/j.jaccpubpol.2005.11.003
72 D.S. Jenkins et al. / Journal of Accounting and Public Policy 25 (2006) 71–90
quality decline. Collectively, these results imply a pervasive earnings quality decline dur-
ing the late 1990s that even high quality auditing was insufficient to fully prevent.
Ó 2005 Elsevier Inc. All rights reserved.
Keywords: Audit quality; Industry-specialist auditor; Earnings quality
1. Introduction
The late 1990s in the US equity markets were characterized by high trading
volumes, record levels of public participation, and price-earnings multiples not
seen in many decades. Subsequently, a number of investment issues and con-
cerns have caught the attention of investors and policymakers charged with
protecting the investment community. A primary issue is the greatly increased
incidence of high-profile audit failures (e.g., Enron), cases in which financial
reports contained material misstatements (e.g., WorldCom), and hundreds of
restatements of financial reports. These problems have arguably impaired the
integrity and trust upon which the healthy functioning of capital markets is
predicated (Edmondson and Tierney, 2002; Byrne et al., 2002).
The reporting problems that manifested in the years that followed, give rise
to a number of interesting research questions. First, did the quality of reported
earnings deteriorate in the late 90s? Second, if earnings quality did deteriorate,
was the auditing community effective in mitigating any such decline? These
questions speak to issues important to investors, auditors and policymakers
alike. They thus motivate our research.
In this paper, we investigate and show evidence supportive of: (a) a substan-
tive general decline in earnings quality occurred concurrent with the late 1990s
and (b) even ‘‘high quality’’ auditors, in particular, industry specialists, were
only partly effective in constraining this decline.
To investigate changes in earnings quality during the period in question, we
utilize two proxies to operationalize the notion of earnings quality: discretion-
ary accruals (hereafter DAs) and value relevance of earnings, as measured by
earnings response coefficients (hereafter, ERCs).3 First, we examine the magni-
tude of reported DAs (e.g., Becker et al., 1998; Krishnan, 2003a,b; Balsam
et al., 2003) of client firms of auditors. The magnitude of DAs is indicative
of the discretion managers have in reporting accruals (Becker et al., 1998)
and researchers often use this measure as a proxy of the degree to which earn-
ings have been managed by management (see Kothari, 2001). Recent research
3
We measure the annual returns-earnings relation, which is best described as a measure of the
association between returns and earnings rather than a measure of the market reaction to earnings
announcements.
D.S. Jenkins et al. / Journal of Accounting and Public Policy 25 (2006) 71–90 73
also supports the use of DAs as a proxy for earnings quality. For instance, Bar-
tov et al. (2000) show that DAs are associated with audit qualifications. Henn-
inger (2001) finds that DAs are associated with litigation against auditors.4
Using the sample period 1990–1999, we employ the Chow breakpoint test
and separate the decade into two periods: 1990–1996 (hereafter Period I) and
1997–1999 (hereafter Period II). Using the absolute value of DAs as a proxy
for earnings quality, we examine whether DAs increased in Period II relative
to Period I. We then examine whether the DAs reported by client firms of
industry specialist auditors decreased, both absolutely and in comparison to
that reported by client firms audited by non-specialists, during the period in
question. If industry specialists fully mitigated any tendency toward decline
in earnings quality that may have occurred during the late 1990s, then the
reported DAs of client firms of industry specialists should not vary as a func-
tion of the time period in question.
Second, to corroborate the results obtained using the DA model, we inves-
tigate the value relevance of earnings (i.e., ERCs) during the 1990s. If earnings
quality did generally deteriorate in the late 1990s, and if this deterioration
decreased the investment utility of earnings numbers, the value relevance of
earnings should reflect deterioration during the time period in question.
Assuming industry specialists were able to mitigate any decline in earnings
quality during Period II, any documented general decline in the value relevance
of earnings should be reduced by industry specialists.
Our results are as follows. First, we find evidence of a substantive decrease
in earnings quality during Period II. In particular, DAs were substantively
higher, and ERCs generally lower, during the period. Second, we find that
there was an increase in the absolute value of reported discretionary accruals
across client firms of both industry specialist auditors and, to a greater extent,
non-specialists. In the sample we test, we find evidence supporting the notion
that there was a widespread decline in earnings quality and that industry spe-
cialist auditors were only partially effective in constraining the decline.
Though generally weaker in magnitude and less robust, the findings are con-
firmed by the results we report for the ERC proxy. Client firms of both special-
ists and non-specialists experienced a significant decline in ERC during the
periods in question. Client firms of industry specialists, however, experienced
a reduced decline in ERC across the periods for one of the three definitions
4
The presence of discretionary accruals could also imply that managers might have managed
earnings to convey private information. In addition, other factors such as measurement error,
economy-wide, industry–specific or firm-specific changes, cyclical effects etc. could affect the
magnitude of discretionary accruals. In this study, we assume that the magnitude of discretionary
accruals reflects opportunistic management of earnings by managers. This assumption is in line
with several papers in this area of research (e.g., Becker et al., 1998) and also recent empirical
evidence (e.g., Bartov et al., 2000; Henninger, 2001).
of industry specialist. Collectively we interpret our results to suggest that, while

industry specialists were perhaps able to mitigate some of the lower earnings
quality that arose in the late 1990s, they were unable to fully eliminate the
decline. As such, we conclude by suggesting our evidence is consistent with
the notion that industry specialists were, at best, only partly effective as gate-
keepers during this challenging market period when so much wealth was in
play and at risk.
Our research contributes to the extant literature on earnings quality by doc-
umenting that changes in earnings quality may be associated with certain unu-
sual stock market events, such as periods of extraordinarily high price/earnings
multiples. We rationalize that this linkage may be explained by changes in eco-
nomic incentives that arise when markets become more optimistic about future
economic conditions and prospects for growth. This change in perceived pros-
pects increases the valuation multiple afforded any dollar of earnings that is
reported. As a result, the incentive to manage earnings will be greater during
such periods.
Second, our work suggests that standard auditing procedures cannot be
relied on to fully stem certain period-specific risks of earnings quality decline,
such as those associated with the kind of stock market conditions that mani-
fested in the late 1990s. There are at least two possible reasons for this result.
First, it may be that the audit community itself is susceptible to the same forces
driving the changed market valuations and the propensity to report earnings
that is of lower quality. In this case, greater insulation from the effects of com-
petitive business forces on auditors may be needed – a remedy already partly
addressed by responsive new regulations such as the Sarbanes-Oxley Act.
Second, it may be that audit technology, applied without consideration of per-
iod-specific risk, is simply insufficient to address the apparent propensity for
compromised reporting integrity during periods when high market multiples
are being awarded by investors. The broad-based approach of recent legisla-
tion such as Sarbanes-Oxley may represent an attempt to counter such techni-
cal deficiency, e.g., by providing alternative means of increasing monitoring
and compliance, including personal accountability on the part of CEOs, better
corporate governance structures, and so forth.
The remainder of the paper is presented as follows. In Section 2 we provide
background and literature review. In Section 3, we detail our methodology,
including sample selection and model descriptions. In Section 4, we describe
our data and present empirical results and in Section 5, we provide conclusions.
2. Background
Because of the aforementioned high-profile audit failures, material misstate-

ments and restatements of financial reports, the credibility of the external
financial reporting process has been severely challenged. An ongoing public

policy debate has emerged in the wake of recent events to identify problems
that may have contributed to the crisis and identify solutions that can restore
public trust and confidence.
One important question is whether the problem extends beyond high-profile
cases that made headlines and may instead be indicative of a broad and perva-
sive problem within the reporting community itself. Some recent academic
research suggests that this may indeed be the case. In particular, Krishnan
and Gul (2002) examine a sample of client firms of Big Six auditors and doc-
ument an increase in accruals-based earnings management (proxied by the
magnitude of discretionary accruals) and a decrease in earnings informative-
ness (proxied by ERC) in the recent period.5
2.1. Earnings quality in the late 1990s
In this paper, we focus on one such event that might arguably explain a
decline in financial reporting credibility–an extraordinary trading period that
has been labeled by the popular press as the ‘‘stock market bubble’’ of the late
1990s. Consider that during the late 1990s, share prices, the levels of popular
indexes such as the Dow Jones Industrials and the S&P 500, trading volumes
and levels of public participation all reached record levels. Of course, none
of these factors alone make the period distinctive. Stock valuations, for exam-
ple, with only brief interruptions, rose throughout the 1980s and 1990s. Price-
earnings multiples, however, for most of this period, remained within historic
norms.
These multiples, particularly from 1997 to 1999, reached levels rarely before
seen in stock market trading. The S&P 500 index, representing stocks of some
of the largest traded firms listed on American exchanges, achieved price-earn-
ings multiples during this period that exceeded 40 (see Shiller (2000) for a com-
plete discussion). We reason that a period in which reported earnings is
afforded an extremely high market multiple would create new incentives to
manage earnings on the part of those involved in the process of financial
reporting. For managers, particularly those whose compensation was based
on stock performance, the incentives would be increased income and security.
Specifically, since higher stock prices increase managers’ stock based compen-
sation, there is a greater reward for managing earnings upward when market
multiples are highest. In addition, expectations of growth were quite high in
the economic environment of the late 1990s. With that, managers felt
5
Prior research has also examined long term trends in the value relevance of earnings. For
instance, Collins et al. (1997) document a decline in earnings value relevance from 1953 to 1993 and
a simultaneous increase in the value relevance of book value. Francis and Schipper (1999) and Lev
and Zarowin (1999) also document long term trend of decreasing earnings value relevance.
compelled to meet those expectations, which created further incentive to man-

age earnings. As a result, earnings quality declined and the risk of financial
reporting failures increased.
2.2. Industry specialist auditors and changes in earnings quality

associated with the period
Assuming earnings quality did evidence a marked decline in the late 1990s, a
question emerges regarding the effectiveness of auditing to constrain any dete-
rioration in earnings quality. Auditors, through the very act of monitoring,
may act to police and mitigate the risk of decline in earnings quality and finan-
cial reporting integrity. All publicly traded firms are audited, so if lower earn-
ings quality manifested in the general population of firms, it follows that
auditing, in general, could not have fully mitigated the impact on earnings
quality of the late 1990s. Audits, however, vary in quality and thus propensity
for monitoring and detection. Thus, it may be that, although audits in general
may not have fully mitigated any decline in earnings quality specifically asso-
ciated with the late 1990s trading period, higher quality audits did. To examine
this possibility, we turn next to one kind of audit that is arguably of higher
quality- audits conducted by an industry specialist.
Prior research has documented that client-firms of industry specialists, pre-
sumably because of higher quality of audits, report superior quality of earnings
(e.g., Gramling et al., 1999; Balsam et al., 2003; Carcello and Nagy, 2002).6
Industry specialist auditors are generally considered to have both the compe-
tence and incentive to perform superior audits relative to non-specialist audi-
tors. Greater industry-specific knowledge and experience presumably help
industry specialist auditors to identify and address industry-specific issues
and problems. Industry specialist auditors are also more likely to make
increased investments in staff training and technology in the industries in which
they have extensive experience (Gramling et al., 1999). Superior industry-
specific knowledge and the resulting better audit technology available to spe-
cialists help audit firms that are industry specialists to perform better audits
(Beasley and Petroni, 2001). As noted by Gramling et al. (1999), audit firms
develop valuable reputations for being industry specialists in the industries in
which they invest substantial resources. An industry specialist audit firm risks
losing its reputation if it performs a low-quality audit. This suggests that indus-
try specialist auditors have increased incentives to perform high quality audits.
Supporting the notion that, as a result of greater economic incentives as well
as professional capability, industry specialist auditors perform superior quality
audits relative to non-specialist auditors, empirical research has demonstrated
6
For a detailed discussion of the literature, see Gramling and Stone (2001).
that industry specialist audit firms command higher fees (Defond et al., 2000;
Craswell et al., 1995).7 The opportunity to earn increased fees gives industry
specialists an economic incentive to guard their reputations by providing
higher quality audits.
Studies in behavioral accounting have suggested a positive impact of indus-
try specific knowledge on the quality of audit task performed. For instance,
Bedard and Biggs (1991) find that auditor-subjects with recent industry experi-
ence perform better in identifying errors. Solomon et al. (1999) conduct an
experimental investigation and conclude (p. 206) that ‘‘focused training and
narrow, but deep, direct experiences obtained by industry specialists primarily
enhance non-error knowledge’’.
Using different measures of earnings quality, researchers have documented
that client firms of industry specialists report higher earnings response coeffi-
cients (Balsam et al., 2003), earnings streams with higher persistence (Gramling
et al., 1999), lower discretionary accruals (Balsam et al., 2003; Krishnan,
2003b) and lower incidence of financial fraud (Carcello and Nagy, 2002) com-
pared to client firms of non-specialist auditors. Similarly, O’Keefe et al. (1994)
document a positive association between industry experience and compliance
with Generally Accepted Auditing Standards (GAAS). Supporting these find-
ings, Shockley and Holt (1983), in a survey, find that within the banking indus-
try, audit firms with the highest market share are generally perceived to be high
quality auditors. Collectively, these studies suggest that the earnings quality of
firms is affected by audit quality, in particular, the high quality auditing offered
by industry specialist auditors. The previous discussion not withstanding, in a
climate laden with pervasive incentives to manage earnings, it may be unreal-
istic to expect that even industry specialist auditors would be able to fully cur-
tail any decline in earnings quality.
3. Methodology
3.1. Selection of periods
In order to measure whether a decline in earnings quality took place during

the late 1990s, along with the effect of industry specialist auditors on any such
decline, we divide the sample into two periods; 1990–1996 and 1997–1999
(i.e., Period I and Period II, respectively). Selection of the breakpoint that
divides the periods is based on evidence on changes in stock market condi-
tions, as defined by price-earnings ratio of the S&P 500 index. Specifically,
7
The Craswell et al. (1995) study examines the Australian audit market and Defond et al. (2000)
focus on the Hong Kong market.
an examination of the S&P 500 price-earnings ratio throughout the 1990s indi-
cates a general increase with a notable acceleration in the increase occurring at
around 1996. This observation is verified by iteratively implementing the Chow
Breakpoint Test (CBT) of structural change (Chow, 1983) for the trend in PE
ratios for the years 1992–1998. The results of the CBTs (not shown) indicate
that the breakpoint for the PE trend occurred in 1996, which is the basis for
the period specification.8
3.2. Measurement of variables
3.2.1. Industry specialist auditors

A dichotomous variable was used to denote if the auditor was an industry
specialist or not. Following Dunn et al. (2000), an auditing firm was classified
as industry specialist (SPL_20) if its market share was greater than or equal to
20% of total market share of its specific industry. Similar to prior studies (Vel-
ury et al., 2003; Dunn et al., 2000; Hogan and Jeter, 1999; Gramling et al.,
1999; Craswell et al., 1995; Craswell and Taylor, 1991), auditor industry mar-
ket share was defined as the proportion of industry revenue audited by an indi-
vidual accounting firm relative to the total industry revenue for all companies
in that industry audited by all public accounting firms. Each industry was
delineated by a two-digit Standard Industry Classification (SIC) Code. To test
the models’ robustness we also define two alternative measures of industry spe-
cialization. First, we increase the threshold of industry market share as previ-
ously defined from 20% to 25% to test whether the results obtained are robust
to alternative thresholds of industry market share. Thus, we also define the
auditor as specialist if the market share of the auditor was 25% or greater
(SPL_25). Second, to mitigate bias towards large clients that is inherent in
using sales base, following Balsam et al. (2003), we also define specialist as
auditor with greatest number of clients in an industry (MOSTCL).
3.2.2. The reporting of discretionary accruals

We first examine if client firms of industry specialists reported higher discre-
tionary accruals during Period II relative to Period I. We use the following
cross-sectional Jones (1991) model to calculate the expected total accruals:
TACCRi;t =TAi;t1 ¼ ai ð1=TAi;t1 Þ þ b1i ðDREVi;t Þ=½TAi;t1
þ b2i ðPPEit =TAi;t1 Þ þ ei;t ð1Þ
8
Since the paper focuses on conditions of the late 1990s, we replicated the subsequent reported
results for sample breakpoints ranging from 1995 to 1998. The results are largely robust to each of
these candidate breakpoints, indicating that the findings are not highly sensitive to the choice of
breakpoint in the late 1990s.
where, for sample firm i at the end of year t:
TACCR total accruals, defined as net income before extraordinary items less
operating cash flows
TA total assets
DREV change in revenue from year t 1 to year t
PPE gross property plant and equipment
e error term
The coefficient estimates generated by this model were then used to calculate
the expected (normal) total accruals. Thus, expected accruals for firm i at the
end of year t are:
EðTACCRi;t =TAi;t1 Þ ¼ ai ½1=TAi;t1 þ b1i ½ðDREVi;t Þ=TAi;t1

þ b2i ½PPEi;t =TAi;t1 ð2Þ
where: E(TACCRi,t/TAi,t1) = expected total accruals scaled by total assets at

the end of year t 1; and other variables are as previously defined.
Because normal accruals change over time due to changes in a firm’s
economic conditions, the model reflects an attempt to control for the
changes in economic conditions by including the effect on accruals associated
with changes in revenues and property, plant and equipment. Separate calcu-
lations were performed for each group of firms with the same two-digit SIC
code and fiscal year. Smaller absolute values of discretionary accruals9 indicate
less earnings management and suggest that earnings exhibit a greater degree
of neutrality and are thus more useful. We control for variables that have
been identified in prior literature as likely to affect the reporting of discretion-
ary accruals such as firm size, operating cash flows and propensity to generate
total accruals (Becker et al., 1998) and leverage (Reynolds and Francis, 2000).
The following model is examined to investigate if client firms of industry spe-
cialists reported higher discretionary accruals in the recent period. A positive
and significant b6 would indicate an increase in discretionary accruals during
1997–1999 period and a negative and significant b7 would indicate that indus-
try specialists were effective in constraining the trend in decline in earnings
quality.
AbsðDISACÞ ¼ b0 þ b1 LTAit þ b2 CFOit þ b3 LEVit þ b4 AbsðTACCit Þ

þ b5 PERIODit þ b6 SPEC PERIODeit ð3Þ
9
Consistent with prior literature, e.g., Balsam et al. (2003), we use absolute value of discretionary
accruals to emphasize the magnitude of the accruals more than the direction. For completeness,
however, we also perform the DA analyses on the positive and negative accruals samples
individually.
where, for firm i at time t:
Abs(DISAC) absolute value of discretionary accruals scaled by lagged total

assets
LTA log of total assets
CFO cash flow from operations scaled by lagged total assets
LEV ratio of long-term debt to total assets
Abs(TACC) absolute value of total accruals scaled by lagged total assets
PERIOD dichotomous variable set equal to one for the years 1997–1999; else
zero
SPEC dichotomous variable set equal to one if auditor is an industry special-
ist; else zero
3.2.3. Returns-earnings relationship

We also examine the strength of the returns/earnings relationship in the two
periods. We control for variables that are likely to affect the returns/earnings rela-
tionship such as the reporting of negative unexpected earnings (Basu, 1997); firm
size (Collins and Kothari, 1989; Collins et al., 1997); growth opportunities
(Collins and Kothari, 1989) and interest rates (Collins and Kothari, 1989).10
We examine the following model to examine the returns-earnings relationship.
Rit ¼ b0 þ b1 LTAit þ b2 LEVit þ b3 GROWTHit þ b4 YIELDit þ b5 NEGit
þ b6 PERIODit þ b7 DEARNit þ b8 DEARNit PERIODit
þ b9 DEARNit PERIODit SPECit þ eit ð4Þ
where for firm i at time t:
R 12 month stock return ending three month after the fiscal year end for
year t
DEARN change in net income before extraordinary items and discontinued
operations from year t 1 to year t scaled by beginning market
value of equity
GROWTH market to book value of equity
NEG dichotomous variable set equal to one if DEARN is negative; zero
otherwise
YIELD yields on long-term US Government bonds for years 1990–1999.11
and other variables are as previously defined.
10
Teets and Wasley (1996) suggest that the returns/earnings relationship can be affected by differences
in the variance of earnings across groups. For our sample, however, we found the variances for earnings
levels and changes across the two sample periods to be similar. Specifically, standard deviations for
earnings levels (changes) were 11% (13%) and 11% (16%) for periods I and II, respectively.
11
We obtained the information on yields on US government bonds from H.15 Release–Federal
Reserve Board of Governors.
If the value relevance of earnings has declined in the post-1996 period, then
we would expect to see a significant and negative b9. Furthermore, if industry
specialist auditors were effective in constraining any such decline in value-rele-
vance, we would expect to see a positive and significant b10.
3.3. Sample selection
The sample for the DA (ERC) study consists of all firms listed on COMPU-
STAT (CRSP and COMPUSTAT) that had the required financial information
for the ten year period 1990–1999. Consistent with prior research (e.g., Krish-
nan and Gul, 2002), financial institutions (SICs between 6000 and 6999) and
utility companies (SICs between 4000 and 4999) were deleted. Similar to
Hogan and Jeter (1999) firms with less than 10 observations in each sample
year in their two-digit SIC codes were deleted. Consistent with Easton and
Harris (1991), to mitigate the effect of outliers, we deleted observations for
which jDEARNjhave values greater than 1.50 in the returns-earnings sample.
To mitigate the effect of outliers for all other variables, the upper and lower
1% of observations are deleted. Finally, we require a constant sample of firms
that exist for the entire 10-year period of the study in order to eliminate the
Table 1
Definiton of variables
Abs(DISAC) Absolute value of discretionary accruals scaled by lagged total assets
Abs(TACC) Absolute value of total accruals scaled by lagged total assets
NDAC Non-discretionary accruals measured as total accruals less discretionary accruals
LTA Natural log of total assets
CFO Cash flow from operations scaled by lagged total assets
LEV Ratio of long-term debt to total assets
PERIOD Dichotomous variable set equal to one for the years 1997–1999; else zero
R 12 month stock return ending three months after the fiscal year end for year t
SPEC One if auditor is an industry specialist and zero otherwise
SPL_20 Dichotomous variable set equal to one if the auditor audits 20% or more of
the industry sales; else zero
SPL_25 Dichotomous variable set equal to one if the auditor audits 25% or more of
the industry sales; else zero
MOSTCL Dichotomous variable set equal to one if the auditor audits maximum number
of clients in an industry; else zero
DEARN Changes in net income before extraordinary items and discontinued operations
from year t 1 to year t scaled by beginning market value of equity
GROWTH Market to book value of equity
YIELD Yields on long-term US Government bonds for years 1990–1999
NEG Indicator variable set equal to one if DEARN is negative; otherwise zero
N Firm-year observations
effect of differences in firms that initially appear in the latter period.12 This pro-
cedure yielded 6370 (2436) firm-year observations for the DA (ERC) study (see
Table 1).
4. Empirical results
4.1. DA study results
4.1.1. Descriptive statistics

Table 2 presents descriptive statistics for the sample firms. Panel A indicates
that the sample firms had mean absolute value of discretionary accruals of
approximately 8.5% of total assets in Period I compared to 14.4% in Period
II. The difference in means is significant, suggesting an overall increase in the
magnitude of the reported discretionary accruals. The increase in positive
(income increasing) discretionary accruals of 7.4% is noticeably larger than
the 4.0% increase reported for negative (income decreasing) discretionary
accruals, indicating a proclivity for employing accruals to increase income.
Despite the documented increase in discretionary accruals, mean total accruals
slightly decreased, but remain at around 9% of total assets across periods.13
The results in Panel B (specialist sample) and Panel C (non-specialist sample)
are similar, although firms in the specialist sample appear to be larger in both
periods than those in the non-specialist sample based on the magnitude of total
assets. In addition, discretionary accruals are larger for the non-specialist sam-
ple in both periods.
4.1.2. Increase in discretionary accruals

Table 3 presents the regression results of Model 3 for the discretionary
accruals study. The results of the DA sample are reported in Panel A for the
three definitions of industry specialist.
Panel A indicates that, for our sample, the absolute value of discretionary
accruals are positively associated with absolute total accruals and negatively
associated with cash flows from operations and size. These results are consis-
tent with prior research (e.g., Balsam et al., 2003), although we do not find
the coefficient on long-term debt to be significant for our sample. The positive
and significant coefficient of PERIOD(b6) indicates an overall increase of
approximately 7.6% in discretionary accruals in Period II for the overall
12
We would like to thank an anonymous reviewer for this suggestion. While this sample
restriction may somewhat induce a survivorship bias, we feel that any resulting detrimental effect is
eclipsed by the benefit of eliminating potential volatility in the data caused by the introduction of
new firms in the latter period.
13
The increase in discretionary accruals with no contemporaneous increase in total accruals is
consistent with Krishnan and Gul (2002).
Table 2
Descriptive statistics—discretionary accruals model
Variable Mean for Mean for Difference in
1990–1996 1997–1999 means (2)–(1)
(Period 1) (Period 2)
Panel A: Pooled sample (N = 6370)
Abs(DISAC) 0.085 0.144 0.059***
Positive DISAC 0.079 0.153 0.074***
Negative DISAC 0.092 0.132 0.040***
Abs(TACC) 0.093 0.092 0.001
CFO 0.207 0.231 0.024*
LEV 0.191 0.211 0.020***
Total assets (in ml $) 814.230 1252.654 438.424***
N 4459 1911
Panel B: Specialist sample (N = 1882)

Abs(DISAC) 0.073 0.100 0.027***
Positive DISAC 0.064 0.106 0.042***
Negative DISAC 0.082 0.093 0.011
Abs(TACC) 0.085 0.082 0.003
CFO 0.267 0.315 0.049*
LEV 0.203 0.235 0.032***
N 1266 616
Panel C: Non-Specialist Sample (N = 4488)

Abs(DISAC) 0.090 0.165 0.075***
Positive DISAC 0.085 0.174 0.089***
Negative DISAC 0.096 0.151 0.055***
Abs(TACC) 0.096 0.096 0.000
CFO 0.184 0.190 0.006
LEV 0.186 0.200 0.014**
N 3193 1295
Note: See Table 1 for variable definitions.
An audit firm is classified as industry specialist if it audits 20% (or more) of industry sales in a given
year. Otherwise, an audit firm is classified as a non-specialist.
*
Denotes significance at 0.10 level.
**
***
sample. An examination of the coefficient of the specialist-period interaction

variable (b7), which is negative and significant at the 1% (5%) level for the
SPL_20 and SPL_25 (MOSTCL) definition of industry specialist, provides evi-
dence that the increase in discretionary accruals across periods was mitigated
by industry specialist auditors. However, analyzing the relative magnitudes
of PERIOD(b6) and SPEC * PERIOD(b7) indicates that the increase in DAs
Table 3
Regression results—DA model
Model 3 : AbsðDISACÞ ¼ b0 þ b1 LTAit þ b2 CFOit þ b3 LEVit þ b4 AbsðTACCit Þ
þ b5 PERIODit þ b6 SPEC PERIODeit
SPL_20 SPL_25 MOSTCL
Panel A: Full sample (N = 6370)
Intercept 0.068*** 0.069*** 0.070***
LTA 0.011*** 0.011*** 0.011***
CFO 0.008** 0.008** 0.008**
LEV 0.003 0.004 0.004
Abs(TACC) 0.720*** 0.720*** 0.719***
PERIOD 0.076*** 0.071*** 0.068***
SPEC * PERIOD 0.036*** 0.030*** 0.015**
R2 0.2832 0.2820 0.2809
Panel B: Positive discretionary accruals sample (N = 3453)

Intercept 0.080*** 0.080*** 0.081***
LTA 0.013*** 0.014*** 0.014***
CFO 0.005 0.005 0.005
LEV 0.007 0.008 0.008
Abs(TACC) 0.881*** 0.881*** 0.881***
PERIOD 0.089*** 0.085*** 0.088***
***
SPEC * PERIOD 0.038 0.033*** 0.037***
R2 0.2631 0.2621 0.2629
Panel C: Negative discretionary accruals sample (N = 2917)

Intercept 0.034*** 0.035*** 0.038***
***
LTA 0.006 0.006*** 0.007***
CFO 0.005 0.005 0.004
LEV 0.009 0.009 0.009
Abs(TACC) 0.718*** 0.719*** 0.718***
***
PERIOD 0.052 0.047*** 0.037**
SPEC * PERIOD 0.032*** 0.023** 0.015
R2 0.3651 0.3637 0.3614
* Denotes significance at 0.10 level.
**
in Period II is not fully constrained by industry specialists. This is evidenced by

the significant absolute coefficient differences between b6 and b714 of 0.40
14
The difference between these coefficients is tested using an F-test of the following linear
restriction: b6 + b7 = 0. The concept here is that if any general decline in earnings quality is
completely offset by industry specialist auditors, these coefficients will be of approximately equal
magnitude with opposite signs.
(p < 0.01), 0.41 (p < 0.01), and 0.53 (p < 0.01) for SPL_20, SPL_25 and
MOSTCL, respectively. Industry specialists (SPL_20) are associated with a
constraint of approximately 47% (=0.036/0.076) of the general increase in
DAs.
The results of the positive and negative discretionary accruals samples in
Panels B and C of Table 3 indicate that the general increase in positive accruals
(approximately 0.09) is somewhat larger than that of the negative accruals sam-
ple (approximately 0.05) and that specialists were able to mitigate both. How-
ever, industry specialist auditors were more effective at moderating the increase
in negative accruals (approximately 50% average moderation for all definitions,
p 6 0.01 for null hypothesis b6 + b7 = 0) than the increase in positive accruals
(approximately 40% average moderation for all definitions, p < 0.01 for null
hypothesis b6 + b7 = 0). This result is congruent with the notion that period-
specific risks of reduced earnings quality were not fully mitigated by the use
of monitoring via an industry specialist auditor. Any such risk would likely
manifest mainly in the form of a bias to manage earnings upward. Hence, in
our results we detect a significant net increase in positive accruals, even when
industry specialists are conducting the audit. Given the earlier discussion con-
cerning incentives to manage earnings upward during period II, this is a some-
what unsettling, although not completely unexpected, result.
4.2. ERC study results
4.2.1. Descriptive statistics

The descriptive results of the ERC study are provided in Table 4. Panel A
presents the results for the full sample, while the results for the specialist and
non-specialist samples are provided in Panels B and C, respectively. Earnings
changes decreased across the periods, but the change is not significant. Total
assets, leverage, and market-to-book ratios increased during the period, but
only growth in assets and leverage were significant. Results across the specialist
and non-specialist samples were qualitatively similar.
4.2.2. Decline in the returns-earnings relation

We next examine whether the ERC, on average, has declined over the period
in question. Table 5 presents the results of Model 4 for the three definitions of
industry specialist. Consistent with prior research (e.g., Fama and French,
1992; Collins and Kothari, 1989), the results indicate that stock returns are
negatively associated with size, leverage, and market-to-book, and positively
related to earnings changes. To examine if the ERC has declined in Period
II, we examine the coefficient of the interaction of DEARN and PERIOD(b9).
The negative and significant b9 coefficient indicates a decline in the ERC in the
late 1990s. The coefficient of the three-way interaction of DEARN, PERIOD
and SPEC(b10) provides evidence as to whether industry specialist auditors
Table 4
Descriptive statistics—ERC model
Variable Mean for Mean for Difference
1990–1996 1997–1999 In Means
(Period 1) (Period 2) (2)–(1)
Panel A: Pooled sample (N = 2436)
DEARN 0.011 0.008 0.003
LTA 5.619 6.123 0.504***
LEV 0.189 0.218 0.029***
GROWTH 2.924 3.307 0.383
YIELD 0.072 0.058 0.014***
N 1704 732
Panel B: Specialist sample (N = 442)

DEARN 0.015 0.004 0.011
LTA 5.505 6.060 0.555***
LEV 0.205 0.212 0.007
GROWTH 2.817 3.574 0.756
YIELD 0.072 0.058 0.014***
N 278 164
Panel C: Non-specialist sample (N = 1994)

DEARN 0.010 0.009 0.001
LTA 5.642 6.142 0.500***
LEV 0.186 0.219 0.033***
GROWTH 2.944 3.229 0.285
YIELD 0.072 0.058 0.014***
N 1427 567
Note: See Table 1 for variable definitions. An audit firm is classified as industry specialist if it audits
20% (or more) of industry sales in a given year. Otherwise, an audit firm is classified as a non-
specialist.
** Denotes significance at 0.05 level.
***
were able to mitigate any of this period-specific decline in the returns-earnings

relation. The b10 coefficient is positive and significant at the 5% level for the
SPL_20 definition of industry specialist. The relative magnitude of the coeffi-
cients b9 and b10 indicate that clients of industry specialist auditors mitigated
the general decline in the returns-earnings relation by approximately 78%
(=0.64/0.82, p < 0.01 for null hypothesis b9 + b10 = 0). However, these results
are not robust to the SPL_25 and MOSCL definitions of industry specialist.15
15
The lack of complete robustness to alternative measures of industry specialization is consistent
with prior research, e.g., Dunn and Mayhew (2004). For a more detailed discussion of this issue see,
for example, Hogan and Jeter (1999) and Gramling and Stone (2001).
Table 5
Regression results—ERC model (N = 2436)
Model 4 : Rit ¼ b0 þ b1 LTAit þ b2 LEVit þ b3 GROWTHit þ b4 YIELDit þ b5 NEGit
þ b6 PERIODit þ b7 DEARNit þ b8 DEARNit PERIODit
þ b9 DEARNit PERIODit SPECit þ eit
SPL_20 SPL_25 MOSTCL
Intercept 0.339*** 0.334*** 0.344***
LTA 0.033*** 0.033*** 0.034***
LEV 0.148*** 0.147** 0.142***
GROWTH 0.004*** 0.004*** 0.004***
YIELD 1.300 1.365 1.304
NEG 0.128*** 0.129*** 0.133***
PERIOD 0.037 0.037 0.037
DEARN 0.942*** 0.942*** 0.937***
DEARN * PERIOD 0.824*** 0.612*** 0.504***
DEARN * PERIOD * SPEC 0.642*** 0.026 0.225
R2 0.0838 0.0809 0.0825
**
In both cases, industry specialist auditors, as so defined, are insignificantly

associated with any mitigation in earnings quality, as proxied for using ERCs.
In summary, and notwithstanding the mixed evidence concerning the effective-
ness of specialists in constraining the decrease, we corroborate, at least gener-
ally, the results we report for the DA model by documenting a period-specific
decline in earnings quality for the client-firms of both specicalists and non-spe-
cialists alike across the study periods.
4.3. Ex-post analyses
4.3.1. Period I analysis

To establish a baseline for the effect of specialists, we next examine the dif-
ferences in earnings quality in Period I. Concerning DAs, the mean difference
for specialist auditors relative to non-specialists was 0.017 (t = 4.35,
p < 0.01), compared to a mean difference of 0.065 (t = 5.12, p < 0.01) dur-
ing Period II. While specialist auditing was associated with higher earnings
quality in Period I, the effect was greatly intensified during Period II. Mean-
while, the ERC difference between specialists and non-specialists in Period I
is positive 0.153, but the difference was not significant (p = 0.40). In compari-
son, the difference in Period II is positive 0.542 and significant (p < 0.01, one-
tail test). Again, this indicates that earnings quality differences between cli-
ents of specialists and non-specialists intensified during the late 1990s. Taken
collectively, these results demonstrate that, while specialist auditors may gener-
ally be associated with increased earnings quality vis-à-vis non-specialists, the
effect may be exaggerated in extraordinary economic periods such as the late
1990s.
4.3.2. Unqualified opinions only

We re-ran Models 3 and 4 after including only those firms that received
unqualified opinions in both periods. The results (not shown) are qualitatively
similar to those obtained from the full samples.
4.3.3. Limitations of the study related to proxy measures

There are certain limitations that should be considered with respect to the
results of the study. For example it is possible that the economic period created
inherent differences in the measurement of the proxies for earnings quality.
Such difference may be caused by greater variability in the measures of discre-
tionary accruals and/or the returns-earnings relation. Along with requiring a
constant sample of firms across the entire study period, we also examined an
alternative measure of discretionary accruals (taken from Kothari et al.,
2005) and analyzed differences in the frequency of loss observations across
periods (which is known to affect the ERC) in order to mitigate the impact
of period-specific differences on proxy measurement. The results are not qual-
itatively affected by either the DA measure or the frequency of loss observa-
tions, the difference of which is insignificant across periods.
5. Conclusion
Given the extraordinary stock market conditions of the late 1990s, we inves-
tigate whether a pervasive decline in earnings quality occurred during this per-
iod and whether industry specialist auditors were effective in constraining any
such decline. Our findings indicate that publicly traded firms reported larger
discretionary accruals and smaller earnings response coefficients in the post-
1996 period, thus suggesting a general reduction in earnings quality. We also
report some evidence that suggests high quality auditors, in particular, industry
specialists, were able to partly constrain this period-specific decline in earnings
quality. The evidence we report, however, is not fully robust to all of our ERC
tests.
Our results, and the implications they point to, should benefit regulators,
policy-makers, and other public servants charged with initiating reforms to
improve audit quality. Recent promulgations, such as the Sarbanes-Oxley
Act of 2002, have legislated increased accountability of board members, audit
oversight responsibilities and procedures, and, in general, a more prescriptive
and standardized approach to professional monitoring, corporate governance,
and oversight activities. These standardized measures are broad-based, being

now required of all publicly traded firms. Such a general and prescriptive
approach seems appropriate in light of the severity and apparent pervasiveness
of the problem at hand. On the other hand, in earlier years, audit quality was
arguably better without the imposition of such rules, including the additional
costs that businesses must incur to meet them. More research is needed to
understand the cross-sectional and intertemporal factors that materially impact
audit quality, thereby causing the risk of audit failure to change across firms
and time. If such conditions can be identified, and the risks quantified, it
may be possible in the future to design regulation that is contextually sensitive
to changes in the risk of impairment of audit and financial reporting quality. In
this way, the cost of regulation can be reduced, making it lighter to bear and
more productive to society at large.
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Journal of Accounting and Public Policy 25 (2006) 71–90

Earnings quality decline and the eﬀect

University of Delaware, Department of Accounting and Management Information Systems,

Keywords: Audit quality; Industry-specialist auditor; Earnings quality

of industry specialist. Collectively we interpret our results to suggest that, while

Because of the aforementioned high-proﬁle audit failures, material misstate-

ﬁnancial reporting process has been severely challenged. An ongoing public

2.1. Earnings quality in the late 1990s

compelled to meet those expectations, which created further incentive to man-

2.2. Industry specialist auditors and changes in earnings quality

3.1. Selection of periods

In order to measure whether a decline in earnings quality took place during

3.2. Measurement of variables

3.2.1. Industry specialist auditors

3.2.2. The reporting of discretionary accruals

where, for sample ﬁrm i at the end of year t:

EðTACCRi;t =TAi;t1 Þ ¼ ai ½1=TAi;t1 þ b1i ½ðDREVi;t Þ=TAi;t1

where: E(TACCRi,t/TAi,t1) = expected total accruals scaled by total assets at

AbsðDISACÞ ¼ b0 þ b1 LTAit þ b2 CFOit þ b3 LEVit þ b4 AbsðTACCit Þ

where, for ﬁrm i at time t:

Abs(DISAC) absolute value of discretionary accruals scaled by lagged total

3.2.3. Returns-earnings relationship

and other variables are as previously deﬁned.

3.3. Sample selection

4.1. DA study results

4.1.1. Descriptive statistics

4.1.2. Increase in discretionary accruals

Panel B: Specialist sample (N = 1882)

Panel C: Non-Specialist Sample (N = 4488)

sample. An examination of the coeﬃcient of the specialist-period interaction

Panel B: Positive discretionary accruals sample (N = 3453)

Panel C: Negative discretionary accruals sample (N = 2917)

in Period II is not fully constrained by industry specialists. This is evidenced by

4.2. ERC study results

4.2.1. Descriptive statistics

4.2.2. Decline in the returns-earnings relation

Panel B: Specialist sample (N = 442)

Panel C: Non-specialist sample (N = 1994)

were able to mitigate any of this period-speciﬁc decline in the returns-earnings

In both cases, industry specialist auditors, as so deﬁned, are insigniﬁcantly

4.3. Ex-post analyses

4.3.1. Period I analysis

4.3.2. Unqualiﬁed opinions only

4.3.3. Limitations of the study related to proxy measures

and oversight activities. These standardized measures are broad-based, being

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